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Thanks to Greg Mankiw for the link…

U.S. food stamp use up sharply, sign of hard times (Reuters) by Charles Abbott

FT.com / Weekend columnists / Tim Harford - Why a tax cut just isn’t fair on teenagers

Tim Harford, aka The Undercover Economist, loves to expose the overlooked effects of governments’ economic policies. For example, both the United States and the UK have recently announced tax cut and rebate plans aimed at putting hundreds of dollars back into the hands of taxpayers, with the hope that households will spend their “free money” from the government, giving the national economies a much needed boost in a time of economic slowdown.

Expansionary fiscal policy, as such a tax cut is known, is a popular tool in times of macroeconomic slowdowns. The hope, of course, is that taxpayers who experience sudden fiscal relief will rejoice upon their newfound disposable income, spending it on goods and services, creating new income for various sectors of the economy, which in turn will be spent on more goods and services. In economics, we call this the “multiplier effect”, the idea being that a certain tax cut (say $150 billion), will ultimately create some multiple of that amount in new spending and income throughout the economy as a whole.

In reality, however, house holds do not spend 100% of a tax rebate or tax cut like those recently passed in the US and the UK. When disposable income increases, household will spend a certain proportion and save or pay off past debts with the rest. The proportion of new income spent is determined by an individual’s marginal propensity to consume, and the proportion saved is based on his or her marginal propensity to save. The greater proportion of additional income that is spent, the larger the multiplier effect in the economy as a whole, and the greater impact expansionary fiscal policy will have towards achieving growth in the economy.

Policy makers, therefore, prefer households spend, rather than save, new income from a tax cut or rebate. According to the Undercover Economist, however, saving a tax rebate is precisely what smart households will do. Why? Because of the basic economic truth learned in the first week of most principles of economics courses: There’s no such thing as a free lunch! Tim Harford explains:

…since neither the UK nor US governments plans to alter its spending plans, these tax holidays will be funded by government borrowing – borrowing that must eventually be repaid. That will require taxes to go up in the future, or not to fall when they otherwise might.

Who should celebrate? Not the typical taxpayer, that is for sure. The tax cut makes no difference to her. If she – assume she is British – had wanted an extra £120 right now, she could already have it in her pocket, either by withdrawing it from savings or by borrowing the money. If she did that, of course, she would later have to repay £120 plus interest. But that is exactly what Darling’s successor as chancellor will require of her. To look at it another way, the rational taxpayer should save the £120 windfall now, keeping it to pay the higher taxes that are surely on the horizon.

A tax rebate financed through government borrowing does not make American or British households any better off. Imagine a scenario where your buddy is experiencing some financial difficulties (maybe he’s lost his job, maybe he’s experienced an expensive injury and has no health insurance…), so you decide you’ll help him out by throwing some cash his way. The catch is, you’re already in debt and have spent more in the last couple of years than your actual income should have allowed. So, in order to help your buddy out, you actually need to borrow money from him. So you give him an IOU, he scrounges up the little cash he can find, gives it to you for the IOU, and you turn around and give it back to him to “help him out.” You can imagine, your buddy is not very thankful and certainly doesn’t feel any richer.

On the macro level, the cash mailed out to American households as part of the recent stimulus package came from new borrowing by the government from American households. All those IOUs issued to finance the stimulus must be paid back, and must be done so through future tax increases. The government has chosen to forgo future spending in order to stimulate current spending. Not everyone should dismay, however, as a certain lucky group will clearly benefit from today’s debt-financed fiscal stimulus packages:

…some people should count themselves wealthier after the tax cut. Anyone expecting to die without making a bequest should be pleased: if the Grim Reaper knocks on the door before the taxman does, he can spend the tax rebate now and leave the bill for some other sucker.

Who will be the fall guy? We don’t know for sure, because we can’t say who a future government will tax. But an obvious candidate would be today’s teenagers, very few of whom are paying income tax right now, but most of whom will pay it in the next few years. Their best hope is that their grandparents add the tax windfall to their bequests rather than blowing the money on a weekend in the sun.

A tax cut today almost certainly implies a tax increase tomorrow. Since teenagers enjoy almost none of the tax cuts today, but will bear the future increases required to pay back new debt, it is you, my students, who should be most opposed to the shortsighted policies being undertaken by US and UK policy-makers.

Update: Once again I have updated this post with a few minor changes. Notably, I have added to graphs illustrating a separate shift in supply and demand for loanable funds. Based on discussions with readers via email, it appears that my previous graph illustrating in one diagram the shifts of both supply and demand was confusing and could be considered double counting the effect of an increase in deficit spending. Thanks again to Professor Chuck Orvis for his valuable input.

*Click on a graph to see the full-sized version

Two markets for money, right? Yes… so do they show the same thing? NO! You must know the distinction between these two markets. First let’s talk about the Money Market diagram.

This market refers to the Money Supply (M1 and M2). The Money Supply curve is vertical because it is determined by the Fed’s (or central bank’s) particular monetary policy. On the X axis is the Quantity of money supplied and demanded, and on the Y axis is the nominal interest rate. A tight monetary policy (selling of bonds by the Fed) will shift Money Supply in, raising the federal funds rate, and subsequently the interest rates commercial banks charge their best customers (prime interest rate). On the other hand, an easy money policy (buying of bonds by the Fed) shifts Sm out, lowering the Federal Funds rate and thus the prime interest rate.

You should also know why a tight money policy is considered contractionary and why an easy money policy is considered expansionary monetary policy. Higher nominal interest rates resulting from tight money policy will discourage investment and consumption, contracting aggregate demand. On the other hand, an easy money policy will encourage more investment and consumption as nominal rates fall, expanding aggregate demand.

Government deficit spending and the money market: Does an increase in government spending without a corresponding increase in taxes affect the money market? You may be inclined to say yes, since the Treasury must issue new bonds to finance deficit spending. After all, when the Fed sells bonds, money is taken out of circulation and held by the Fed, thus it’s no longer part of the money supply.

When the Treasury issues and sells new bonds, however, the money the public uses to buy the bonds is put back into circulation as the government spending is increased. Therefore, any leftward shift of the money supply curve caused by the buying of bonds by the public is offset by the injection of cash in the economy initiated the government’s fiscal stimulus package takes effect (be it a tax rebate or an increase in spending). Therefore, money supply should remain stable when the government deficit spends.

Now to the loanable funds market. Loanable funds represents the money in commercial banks and lending institutions that is available to lend out to firms and households to finance expenditures (investment or consumption). The Y-axis represents the real interest rate; the loanable funds market therefore recognizes the relationships between real returns on savings and real price of borrowing with the public’s willingness to save and borrow.

Since an increase in the real interest rate makes households and firms want to place more money in the bank (and more money in the bank means more money to loan out), there is a direct relationship between real interest rate and Supply of Loanable Funds. On the other hand, since at lower real interest rates households and firms will be less inclined to save and more inclined to borrow and spend, the Demand for loanable funds reflects an inverse relationship. At higher interest rates, households prefer to delay their spending and put their money in savings, since the opportunity cost of spending now rises with the real interest rate.

Government deficit spending and the loanable funds market: We learned above that only the Fed can shift the money supply curve, but what factors can affect the Supply and Demand curves for loanable funds? Here’s a few key points to know about the loanable funds market.

• When the government deficit spends (G>tax revenue), it must borrow from the public by issuing bonds.
• The Treasury issues new bonds, which shifts the supply of bonds out, lowering their prices and raising the interest rates on bonds.
• In response to higher interest rates on bonds, investors will transfer their money out of banks and other lending institutions and into the bond market. Banks will also lend out fewer of their excess reserves, and put some of those reserves into the bond market as well, where it is secure and now earns relatively higher interest.
• As households, firms and banks buy the newly issued Treasury securities (which represents the public’s lending to the government), the supply of private funds available for lending to households and firms shifts in. With fewer funds for private lending banks must raise their interest rates, leading to a movement along the demand curve for loanable funds.
• This causes crowding out of private investment.

Another, simpler way to understand the effect of government deficit spending on real interest rates is to look at it from the demand side.

• Deficit spending by the government requires the government to borrow from the public, increasing the demand for loanable funds. In essence, the government becomes a borrower in the country’s financial sector, demanding new funds for investment, driving up real interest rates.
• Increased demand from the government pushes interest rates up, causing banks to supply a greater quanity of funds for lending. The private, however, now has fewer funds available to borrow as the government soaks up some of the funds that previously would have gone to private borrowers.
• This leads to the crowding out of private investment, in which private borrowers face higher real interest rates due to increased deficit spending by the government.

What could shift the supply of loanable funds to the right? Easy, anything that increases savings by households and firms, known as the determinants of consumption and saving. These include increases in wealth, expectations of future income and price levels, and lower taxes. If savings increases, supply of loanable funds shifts outward, increasing the reserves in banks, lowering real interest rates, encouraging firms to undertake new investments. This is why many economists say that “savings is investment”. What they mean is increased increased savings leads to an increase in the supply of loanable funds, which leads to lower interest rates and increased investment.

On the other hand, an increase in demand for investment funds by firms will shift demand for loanable funds out, driving up real interest rates. The determinants of investment include business taxes, technological change, expectations of future business opportunities, and so on (follow link to our wiki page on Investment).

It is important to be able to distinguish between the money market and the market for loanable funds, as both the AP and IB syllabi xpect students to understand and explain the difference between these concepts.

pintprice.com - the price of beer anywhere in the world

The theory of purchasing power parity (or PPP) holds that in the long run, the price of a particular basket of goods should adjust across countries and currencies to “cost” the same amount regardless of the currency the goods are denominated in. In other words, one dollar should buy the same amount of “stuff” in the US as it does in Mexico, China, the Netherlands or anywhere else in the world. If a dollar buys MORE in one of these countries once it’s been converted to the local currency, it implies that the local currency is undervalued and should adjust in the long run to achieve parity in the amount it can purchase in dollar terms.

One popular measure of purchasing power parity, devised by the folks at the Economist magazine’s intelligence unit, is the Big Mac Index, which measures the price of McDonald’s Big Macs in over 100 countries where they can be purchased. You can read more about this index here.

The Economist magazine recently reported on an new alternative to its own PPP index, “the Price of a Pint”:

Barflies around the world provide a useful service for their beer-drinking comrades at PintPrice.com. The prices of pints of lager are compared on the basis of anecdotal evidence from beer-drinkers around the world, so figures are regularly updated. There are some surprising results. Beer in Zambia and Burundi seems eye-wateringly expensive considering that they are among the world’s poorest countries. The French overseas départments of Guadeloupe and Martinique charge just about as much as in mainland France. Beer-loving America and Britain fall somewhere in the middle. Happily for sports fans at the Beijing Olympics, a pint in China is just $2.46.

I thought it might be useful to some of our graduating seniors planning their summer vacations or gap years. Pay close attention to the data in this table.

(source: http://www.economist.com/displayStory.cfm?story_id=11333131)

So, if cheap beer is a priority in your vacation decision, it looks like North Korea and Myanmar are ideal destinations. I must say, I am relieved to see that Switzerland, my own new home, is not in the top ten… but it is far from cheap.

The website will tell you the average price of a pint of beer in any country in the world, and then break it down to cities within each country. In Zurich, my soon to be home, a pint costs the equivalent of $6.57 US. Compared to my hometown of Seattle, Washington, where a pint goes for $3.25, that’s exactly double the price! Surprisingly, however, a pint of beer here in Shanghai goes for a shocking $5.15, more than double the Chinese average of $2.35.

Apparently, the price of beer has more to do with the local supply and demand than with relative exchange rates. Where the Big Mac Index offers a rather genuine approach to determining purchasing power parity (since the Big Mac is an identical product sold by the same restaurant facing similar costs in over 100 countries), a pint of beer is a bit more subjective a measure of PPP. Quality of beers clearly differ in locales as diverse as North Korea and Luxembourg, not to mention the incomes of beer drinkers, the number of domestic brewers, excise and value added taxes, consumers’ price elasticities of demand, and so on.

As summer vacation approaches, however, vacation planners may care to take into account the “Price of a Pint” index of purchasing power parity. Clearly, one’s dollars will go much further at bars in some places than others.

I know what you 18 year old American high school grads are thinking, “Mexico or Canada?” You’ll just have to follow the link to find out!

(Disclaimer: Mr. Welker is in no way encouraging his former students to travel to certain places based solely on the cheap price of beer there, merely to avoid places where beer is clearly out of their price range!)

FT.com / Columnists / Wolfgang Munchau - Inflation and the lessons of the 1970s

It seem that everyone’s speculating about the US economy today. Recession or no recession, that is the question. The economy has even surpassed the Iraq War as the number one issue in the US presidential race! John McCain, who has publicly admitted that economics is not his strong suit, may just find himself in trouble in a general election where the most important concern among voters is the economic situation.

So what IS that situation, anyway? Is the US in a recession? In other words, has real gross domestic, or total output in the US economy, actually declined over the last six months? Technically, the answer is no. My fellow blogger, Steve Latter, explains this clearly here. What is true, on the other hand, is that the current situation shares many similarities to the global economic slowdown that did occur in the 1970s.

In 1973 OPEC, the newly formed oil cartel consisting at the time of only Arab states, reduced its output of oil and cut off exports to the United States in response to US support of Israel in the Yom Kippur War, in which the Israelis officially occupied the Palestinian territories of the West Bank and Gaza and seized the Golan Heights from the sovereign nation of Syria. To punish the US for its position on this conflict, OPEC cut off supplies of oil to the west, driving gas and energy prices upwards by 70%, triggering a supply shock characterized by a decline in total output and an increase in both unemployment and inflation, a phenomenon known as stagflation: a macroeconomic policy maker’s worst nightmare.

Recently the world has seen a similar (albeit of a different cause) rise in the price of oil and energy prices. Today the rise in energy prices is driven primarily by rising demand, rather than reduced supply (since the 1970s the OPEC cartel has grown to include many non-Arab nations, making it harder to achieve collusion to restrict output and drive up oil prices). Global demand for oil has risen steadily, driven ever higher due to rapid growth in China and other developing nations, and exacerbated by the falling value of the dollar, the currency in which oil prices are denominated.

The supply shocks of today have combined with falling aggregate demand in the US due to weak consumer spending to slow real growth rates to nearlry 0%. So technically, the US has avoided a recession, but the effect on American workers and consumers may be just as painful as the real recession of the 1970s. In order to prevent the “r” word from becoming a reality today, central banks (including the US Fed) have eased money supplies, lowering interest rates, fueling even greater increases in the price level.

…the global weighted average inflation rate will be 5.4 per cent this year, while the global money market interest rate is currently only 4.3 per cent. This means that global short-term real interest rates are negative – at a time when inflation is rapidly accelerating. As monetary policy has been excessively accommodating for more than a decade, inflationary pressures have built up in the global economy.

Central bankers like Ben Bernanke have to make tough decisions sometimes, weighing the trade-off between unemployment and inflation, and determining their monetary policies based on whatever they deem to be the “lesser of two evils”. Rising energy prices have forced firms to cut either cut back their production and raise the price of their products, both actions that result in less overall spending and output in the economy. Falling house prices have led consumers to cut back their own spending, further reducing demand for firms’ output. These factors have all pushed the unemployment rate from around 4.8% a year ago to 5.1% today, which combined with an estimated additional 3-5% of American workers having dropped out of the workforce, (referred to by the Department of Labor as “discouraged workers”) paints a pretty ugly picture of the reality for the American worker today.

The harsh reality of the weak labor market has led Mr. Bernanke and the Fed to pursue an expansionary monetary policy aimed at avoiding further increases in the unemployment rate and decreases in the GDP growth rate. Expansionary monetary policy means lower interest rates, with the goal being increased consumption and investment, both factors that could worsen the inflation problem already experienced thanks to the global supply shock. Evidence indicates that the inflation problem, even in the US where slow growth usually leads to lower price levels, is not going away:

In the US, a survey-based measure of inflationary expectations recently showed an increase to more than 5 per cent. I would estimate there are now several hundred basis points of difference between the current Fed funds rate and an interest rate that would be consistent with price stability in the medium term.

…meaning the Fed, in its attempt to avoid recession and rising unemployment, has created a condition where real interest rates are actually negative, a highly inflationary condition. All this wouldn’t be so bad if wages in the US were rising along with the price level. This however, does not appear to be happening:

The main difference between the situation in the 1970s and now is today’s absence of wage inflation, which explains why absolute inflation rates are a little more moderate. I guess this is probably because of some combination of deregulated labour markets and globalisation. But the lack of wage-push inflation is not necessarily good news. Falling real wages mean falling disposable income and tighter credit conditions mean less borrowing for consumption.

Rising prices for energy, transportation and food have put American households in a tough situation. In the past, periods of inflation have often been characterized by rising wages, meaning the full brunt of nominal price level increases was not entirely born by the American worker. Today, on the other hand, a recession has thus far been avoided, but the combination of record numbers of “discouraged workers”, rising unemployment and inflation may make the pain of our current economic situation just as real as recessions of the past.

In the words of billionaire investor and economic sage Warren Buffett just today:

“I believe that we are already in a recession… Perhaps not in the sense as defined by economists. … But people are already feeling the effects of a recession.”

“It will be deeper and longer than what many think,” he added.

Discussion Questions:

1. What is the difference between nominal and real GDP? Which must decline in order for the economy to be in a recession?
2. What impact do rising energy prices have on the behavior of individual firms?
3. Why are low interest rates likely to make the inflation problem even worse?